Tag Archives: Bond Investing

Checking Up On Workhorse Bond Funds

At RIA Advisors, we do ongoing research on investments for managing client portfolios, of course. And we recently reassessed some popular bond funds. The results might be interesting for readers.

We looked at a group of bond funds that often make short lists for advisors – DoubleLine Total Return (DBLTX), DoubleLine Core Fixed Income (DBLFX), PIMCO Total Return (PTTRX), Baird Aggregate Bond (BAGIX), Dodge & Cox Income (DODIX), Western Asset Core Bond (WATFX), and Metropolitan West Total Return (MWTIX). We started with five year returns and Sharpe Ratios. That’s not a comprehensive analysis, but it’s where we began. Here’s what we found out.

DoubleLine Total Return’s 3.10% annualized return was the second best over the five years through January 2019, but that fund also had the best Sharpe Ratio of 1.16%. That means the fund delivered the best return per unit of volatility among this group of “usual suspects” on most advisors’ short lists. Lots of people think of the fund’s manager, Jeffrey Gundlach, as a gunslinger, who takes a lot of risks. That may be because of his outspoken and frank webcasts, which many investors, including the group here at RIA Advisors, find informative. But the truth is Gundlach runs risk-averse funds. When he’s done something unusual, such as his buying Alt-A mortgage-backed securities for the Total Return fund after the financial crisis, it’s been justified.

Those Alt-A’s probably delivered a ton of return in the first few years the fund owned them, so the fund’s gaudy post-crisis returns (more than 9% in each of the calendar years 2011 and 2012) might be a thing of the past. But that doesn’t mean the fund is any less attractive or that it can’t continue to beat most of its peers and the Bloomberg Barclays US Aggregate.

Western Asset has the best five-year annualized return at 3.44%. But its Sharpe Ratio of 0.92% shows that investors have to tolerate some volatility to achieve those returns. We also looked at how the funds – or the funds their current managers ran – did in 2008, and Western Asset had a difficult time in that stressful period. The firm went out on a limb at the wrong time.

PIMCO Total Return was the best performer in 2008, but those were the days when Bill Gross was at his peak. For the past five years, the fund looks more like the index in terms of its returns and volatility, but its new management team doesn’t own that entire record. Mark Kiesel, Scott Mather, and Mihir Worah have led the fund for a little more than 4 years, since September 26, 2014, and the fund’s 2.53% annualized return for the three years through January 2019 is better than those of most of its peers and than the index’s 1.95% annualized return.

Dodge and Cox Income was its usual solid self, with a 2.91% annualized return and a 0.90% Sharpe Ratio. During the crisis it lost 29 basis points, much better than the nearly 500 the average intermediate term bond fund lost, though behind the 5.24% return of the index.

Baird Aggregate has been solid as well. It has produced a 2.84% annualized return for the recent five-year period with a 0.76% Sharpe Ratio. In 2008, it dropped a little more than 2%, better than the category average, but worse than the index.

Finally, Metropolitan West has been lackluster. The fund has lagged the index with its 2.44% annualized return for the recent five-year period. However, it has surpassed the 2.25% return for the category average. The fund’s 0.67% Sharpe Ratio has surpassed those of both the index and the category average. So the fund has delivered better volatility adjusted returns than the index and category average. In fact, it’s Sharpe Ratio has also surpassed that of the PIMCO Total Return Fund.

Incidentally, it’s interesting to note how the Morningstar fund category average differed from the index in 2008 (-4.7% for the category average and 5.24% for the index) . That divergence results from the fact that the index is U.S. Treasury-heavy, and Treasuries did well in 2008. The average fund, however, often tries to beat the index by owning lots of corporate bonds or by taking other credit risk. And that was decidedly the wrong move in 2008, when the safest securities were the most loved.

There are other funds we could have included here such as PIMCO Income, Loomis Sayles Bond, Delaware Diversified Income, BlackRock Total Return, Guggenheim Total Return, JPMorgan Core plus Bond, and Lord Abbett Total Return but we had to make the cut somewhere for this article. We monitor those funds and others routinely, and so should other advisors who aren’t fully dedicated to passive funds.

The Other Face Of Risk – Bonds

Usually, when it’s a good time to own high quality intermediate term bonds – those that serve as workhorses of most investors’ portfolios, it’s a bad time to own “high yield” (a nice marketing term for “junk”) bonds, and vice versa. That’s because lower interest rates provide a good climate for relatively safe bonds that don’t deliver much yield, and because the economic weakness that low rates signal is often a danger to shaky borrowers.

Conversely, the rising rates that can inflict duration-related damage to safer, lower yielding bonds usually coincide with a robust economy that’s good for junk bonds. So it’s not often that the climate is good or bad for both high-quality intermediate term bonds and high yielding junk bonds.

But, in a note to its investors, the Los Angeles-based value investment firm FPA Funds has just argued that the current environment is bad for both the typical portfolio bond workhorses and more exotic high yielding fare. First, there is a disagreement between the yield curve and the implied inflation that the 10-Year TIPS bond is signaling. The yield curve is flat, implying that investors anticipate deflation. After all, the only reason an investor in longer term bonds would accept a marginally higher yield over a shorter term bond is if the investor anticipates deflation and lower rates in the future. However, that seems unlikely to FPA New Income Fund (FPNIX) portfolio managers Thomas Atteberry and Abhijeet Patwardhan and FPA product specialist Ryan Leggio, since the difference in yield between the 10-year TIPS bond and the 10-Year Treasury is around 2 percentage points now, indicating an anticipation of 2% inflation.

But if inflation – or at least some tepid alternative to deflation – is on the horizon, doesn’t that mean that it’s a good environment for junk bonds? Not so fast say Atteberry, Patwardhan, and Leggio. The high yield “spread” – the difference in yield between high yielding corporate bonds and Treasuries – is very low. That means investors aren’t getting paid much to take the credit risk of owning high yield bonds. That’s especially true since leverage is high among corporate borrowers and covenant quality levels are low. A covenant is a legally binding agreement between borrowers and lenders designed to protect the interests of both parties. Low covenant quality means borrowers don’t have to meet specific requirements.

The authors note that “this is only the third time in the past twenty years when the yield curve has been this flat while at the same time high yield spreads have been this tight.” The upshot of their analysis is that it’s a good time for bond investors to reduce both credit and duration risks. The FPA New Income fund, accordingly, has a short duration, and is reducing credit risk. The fund is avoiding unsecured corporate bonds, and favors secured bonds, for example. It has around 8% of its portfolio in corporate bonds overall compared to 31% and 39%, respectively for funds in the Morningstar Intermediate-Term  Bond and Short-Term Bond Fund categories. As an alternative the fund prefers highly rated asset-backed securities which absorb 57% of its assets. Altogether, 71% of the fund’s assets are in AAA-rated securities.

FPA New Income has always been a “belt-and-suspenders” bond fund from the time legendary investor Bob Rodriguez ran it. It’s managers dislike posting negative return numbers. This has caused them to miss some rallies in bonds. For example, the fund has posted a 2.04% annualized return for the past decade ending in February 2018, while the Bloomberg Barclays US Aggregate Index has delivered a 3.60% annualized return over that time. But the fund’s willingness to “shoot only in a target rich environment” also means it has kept investors safe since 1984, including a 4.31% return during the financial crisis year of 2008 when so many bond funds missed the credit problems of their holdings and faltered as a result. Also, besides never posting a negative return in a calendar year since inception, over the 30 year period ending in February 2018, the fund achieved a 5.85% annualized return versus the 6.13% annualized return of the index. Ten years is a long time, but it’s worth considering whether the fund’s underperformance over the last decade indicates more alarming things about the prevailing credit and interest rate conditions than about its approach.